Chesapeake Energy: Hunting Value, Not Land

The recent surge in natural gas prices isn't benefiting investors in natural gas producer Chesapeake Energy (NYSE: CHK) . The stock actually declined during the polar-vortex winter. Even though natural gas inventory levels have fallen below the lows of the last five years, the futures price for the fuel source used to generate electricity hasn't moved much. In essence, the market still isn't convinced that a long-term structural change has occurred in the natural gas market.

Chesapeake Energy remains one of the largest natural gas producers despite a move to focus on greater oil production. The company projects approximately $5.4 billion in capital expenditures during 2014, which will be nearly completely funded via operating cash flow. Other energy producers including Halcon Resources (NYSE: HK) and SandRidge Energy (NYSE: SD) are encountering the same issues of capital efficiency not leading to stock gains.

Unfortunately all three companies face spending cuts and have plans to divest further assets that will limit total production growth. Meanwhile, aggressive hedging could limit the benefits of soaring natural gas prices. In addition, Chesapeake Energy is still struggling from high gathering and transportation charges in areas of aggressive growth. It is also hurt by minimum volume-commitment charges in the areas that it pulled back from in natural gas. The shift form aggressive wildcatter to conservative producer continues to impact the company and confuse the investment community.

Adjusted production growthThe market clearly prefers growth profiles, and the continued divestitures by Chesapeake Energy hurt total production growth. While it is important to understand that the drilling program is producing 8% to 10% annual adjusted production growth, the requirements to divest assets and manage debt hurt the growth profile. Without the divestitures, the company would need to lower capital expenditures and limit growth.

Chesapeake is targeting generating up to 4% production growth on a 20% reduction in capital expenditures. Due to divestitures in 2013, natural gas production might actually drop while oil production increases by 1% to 5%. In total, the company plans to spud 1,100 gross operated wells, unchanged from 2013 activity levels -- a good sign for capital efficiency though questionable as to the timing.

Likewise, SandRidge Energy sold Permian assets during 2013 and recently unloaded Gulf of Mexico assets that were producing 23.5 MBoe/d to little fanfare. While the Mid-Continent producer now forecasts 26% organic production growth in 2014, the previous guidance was only 12% growth.

Halcon Resources recently lowered its 2014 capital spending budget by 14%. In addition, it plans to divest $300 million to $400 million worth of non-core assets in 2014. These divestitures are on top of $300 million worth of assets sold in 2013, which reduced production levels. All of this news led the stock price to new 52-week lows.

HedgesRegardless of where natural gas prices move in 2014 and beyond, it may not matter if Chesapeake and other producers have aggressively locked in prices. For 2014 production, the company hedged 47% of projected production at an average price of $4.17 per mcf. Additionally, the company has entered into three-way collars on 21% of estimated production between $4.09 and $4.38.

When SandRidge reports earnings on Feb. 27, one major key will be whether it used the polar vortex to increase hedges on natural gas. The low natural gas inventories won't provide much upside if production was already sold at low prices.

Bottom lineUnfortunately, all of the moving parts make it difficult to grasp whether Chesapeake is really capturing value. Natural gas prices are surging and inventories plunging, yet the energy producer is still shifting away from natural gas and cutting capital spending by 20%. It is clear that Chesapeake has become more efficient with capital, but it might just be making that move when it could be capturing value by drilling for suddenly hot energy sources in high demand.

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